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INCORPORATING RISK AND UNCERTAINTY INTO REAL ESTATE VALUATION AND INVESTMENT APPRAISAL

CHAPTER ONE

 INTRODUCTION

1.0       Background to the Study

Valuation is the process of estimating price in the market place. Such estimation will be affected by uncertainties. Uncertainty in the comparable information available; uncertainty in the current and future market conditions and uncertainty in the specific inputs for the subject property. These input uncertainties will translate into an uncertainty with the output figure, the valuation (French, 2007).The terms ‘‘development valuation’’ or ‘‘development appraisal’’ refers to professional studies to determine the feasibility and viability of the proposed improvement on land. (Ajayi, 1996) described such appraisals as pre development feasibility/viability assessments which provide a client with a measure of the likely project costs revenues and profitability involved in undertaking a development scheme.

It is generally agreed that uncertainty is due to the lack of knowledge and poor or imperfect information about all the inputs that can be used in the valuation analysis (Byrne, 1995). The terms risk and uncertainty are often used interchangeably. Risk is seen as a euphemism for uncertainty. However, this colloquial use of the words is unhelpful in identifying the principal issues involved. It is important to define these words more precisely. Definitions and discussion about risk and uncertainty are the cornerstone of a number of papers and books (Bryne, 1995; Hargitay and Yu, 1993; Pellat, 1972; Pyhrr, 1973;Robinson, 1987;Sykes, 1983;Whipple, 1988;Wooford, 1978).

Baum and Crosby (1988) opined that risk/return is fundamental focus in modern investment analysis. Sophisticated investors, especially in more advanced property markets like those in the US and UK, are increasingly requiring downside risk analysis and adjustment from Valuers/appraisers in valuation and investment analysis. (Ogunba and Ajayi, 2007; Ogunba, 2008).Risk and uncertainty are inherent parts of the valuation process because the valuer is unable to specify and price accurately all current and future influences on the value of the asset (Adair and Hutchison, 2005). Valuation estimate has therefore been described as a “snapshot” in time that is meant to provide market price at a single point in time. It is an estimate and any estimate is uncertain (Joslin, 2005). Uncertainty comes up in property valuation due to imperfect information or lack of knowledge of all the inputs that will be required in the derivation of the estimate of value. Eliminating uncertainty from property valuation will therefore not be possible as no valuer has perfect information about all the circumstances that can impact on the outcome of the exercise at his disposal. Unless a property is actually sold to determine market price, any estimate is uncertain (Lorenz, Truck and Lutzkendorf, 2006). The role of the valuer is therefore to assess current market conditions and from a “sea of uncertainty” to produce a single judgement (Joslin, 2005; Lorenz, Truck and Lutzkendorf, 2006).

Over four decade ago, Ratcliff (1965) When he remarked that the need to analyze risk in investment analysis; “we must recognize that the value of a property cannot be expressed in a single unchallengeable figure. The appraiser must frankly admit that his predictions are fraught with various degree of dependability. Thus, he is responsible for giving his client (the investor) the benefit of his opinion of the degree of certainty of his findings, expressed as a probability qualification to the value figure in his report”. The argument raised by (Ratcliff, 1965) has been gaining support from UK authors such as Baum et al (2000); Mallinson and French (2000); Dubben and Sayce (1991) and Enever (1981) There has been similar campaign for this in Nigeria too of late see Ajayi, (1994), Aluko (2000) and 2007; Bello and Babajide, 2005; Otegulu, Mohammed and Babawale 2011; Ajayi , 2014).

Today there has been a remarkable structural changes in the economy. The erstwhile optimism of the 1970 and 1980’s has changed drastically. The development appraisal upon which decision-making in property development is based is fast becoming more difficult to make in our dynamic and unstable economic system (Bello and Babajide, 2005).

1.2       Statement of Research Problem

Property valuation profession in Nigeria has consistently failed to accommodate the new challenges of clientele in the country who are continuously attaining some higher level of sophistication (Ogunba and Ajayi, 2007). This is a dangerous trend bearing in mind that poorly prepared property valuations have had far reaching negative consequences across the globe. A classic instance is the Schneider Affair in Germany where the collapse of Jorgen Schneider’s business due to its indebtedness of DM5Billion to 40 banks exposed the prevailing poor valuation standard and education in Germany in the mid 1990s ( Gilbertson and Preston, 2005; Otegbulu and Babawale, 2011). The Savings and Loan Crisis in the United States and the Asian Financial crisis are other instances of where poor property valuation practices have wrecked far reaching havoc. The Asian crisis was triggered by the collapse of the Bank of Bangkok under the weight of property loans with globalization ensuring that a domino effect is experienced in other Asian economies as equity prices in these countries went bearish.

While so many studies have been conducted in the area of valuation accuracy and rationality of property valuation carried out by practitioners in Nigeria, no known attempt has been made to examine risk and uncertainty in valuation reports. The extent to which uncertainties have been expressed by Nigerian valuers has been largely uninvestigated. While Oluwunmi et al. (2011), Aluko (2007), Ayedun et al. (2011) and Adetokunboh et al. (2012) all focused on the assessment of the satisfaction of lender clients with the quality of mortgage valuation reports in the country, Babawale (2012) had in the process of assessing the current standard of real estate valuation practice in the country examined the compliance of valuation reports with International Valuation Standards. No known study (to the best of my knowledge) had examined the incorporation of risk and uncertainty into Nigerian valuation and investment appraisal reports.

Ogunba (2002) stated that risk and uncertainty problem is apparently not adequately recognized in the appraisal practice as it is presently been conducted. It draws more from the observation that against the background of unreliability, inadequate consideration of risk by the appraiser makes his profession lag far behind the field of general finance and might indeed lead to the profession being considered obsolete (Olaleye, Aluko and Ajayi, 2007).

1.3       Aim and Objectives

The aim of the study is to investigate how Nigerian Valuers account and communicate risk and uncertainty to client in property valuation and investment appraisal

Objectives

1.      To investigate the level of understanding/awareness and application of risk analysis

2.      To identify the various types of risk affecting real estate investment in Nigeria

3.      To examine the technique employed by Nigeria real estate Valuers, if any, in incorporating and reporting risk and uncertainty in real estate valuation and investment appraisal

4.      To evaluate the adequacy of the techniques often employed  by Nigerian real estate  Valuers in incorporating and reporting risk and uncertainty in real estate valuation and investment Appraisal

5.To proffer appropriate techniques for incorporating and reporting risk and uncertainty in real estate valuation and appraisal in the light of the present economic realities in the country and best practices.

1.4            RESEARCH QUESTION

1.      What is the level of understanding/awareness and application of risk analysis

2.      What are the various types of risk affecting real estate investment in Nigeria

3.      What techniques are employed by Nigeria real estate Valuers, if any, in incorporating and reporting risk and uncertainty in real estate valuation and investment appraisal

4.      What are the adequacy of the techniques often employed  by Nigerian real estate  Valuers in incorporating and reporting risk and uncertainty in real estate valuation and investment Appraisal

5.      What are the most appropriate techniques for incorporating and reporting risk and uncertainty in real estate valuation and appraisal in the light of the present economic realities in the country and best practices.

1.5       Significance of the Study

The importance of development/investment appraisal lies in the need to determine the viability of proposed development projects; to attract development finance; to attract and convince a joint developer on the profitability of investing in the development; to enable the developer  in making choice between two or more alternative investments; and to determine the type of development to which a particular piece of land could profitably be put as well as the intensity of use (Ogunba, 2004). Real estate investment valuation and appraisal is the careful estimation of all factors which make value. Therefore a project is viable or profitable if the value (benefit) in relation to the cost is positive (Okoh, 2008). According to Ajayi (2014) incorporating risk in real estate appraisal is very crucial in real estate development project because it guides the decision maker in the overall risk management process by identifying such factors that have potential impact on the conceived project which may likely affect the expected income, timely completion and successful execution of the project. Thus without the risk being assessed or analyzed, responding to it and controlling it will be impossible. Therefore the study is conceived to determine how property development appraisal can be improved upon to minimize the exposure of financiers and end users of development appraisal (estate surveyors & valuers, developers, development financiers) from downside risk in property development.

Financial appraisal of capital investment decision forms an important aspect of feasibility and viability studies especially for private investors whose main target is to maximize profit (Ibiranke, 1998). Risk occurrence in real estate valuation and appraisal must be considered and should not be under estimated as it affects the project management, financing and development process with regards to project management, delay project cost overrun and quality of product (Khumpaisal and Chen, 2010). Thus, the interaction of these actors coupled with the wide range of variables involved in the real estate investment requires sophisticated risk modeling which would also help developers to structure the decision making process(Khumpaisal,Ross and Abdulai, 2010).In real estate investment, decision once taken may be irreversible or at least costly to amend. Therefore, it is important for investment decisions to be appraised and the need for a reliable technique for appraising real estate investment cannot be over emphasized (Zakariyyah, 2012)

Olaleye (1998) opined that much as the topics of development appraisal and risk analysis in real estate investment and development are of some academic interest, it is noticed that real estate practice in Nigeria has not embraced them fully. Hence, the need to carry out a study which incorporates risk and uncertainty into real estate valuation and investment appraisal.

1.6       Scope of the Study

The study focused on selected real estate firms that operate in Lagos only. According to the directory of Nigerian Institution of Estate Surveyors and Valuers (2014)  more than fifty (50) percent that is about 309 of registered firms in Nigeria have their headquarter in Lagos metropolis indicating that Lagos state has the highest population of Estate Surveyor and Valuers firms in Nigeria. This serves as a basis for choosing Lagos based practitioners as the study population which will reflect from the number of Valuation and Investment Appraisal that have been carried out by the Estate Surveyors and Valuers firms.  It did not attempt to investigate the thoroughness of market surveys or assess the accuracy of development appraisal and valuation report because there is need to first of all ascertain whether risk and uncertainty are incorporated in valuation and investment appraisal

1.7       Limitation of the Study

1.      There were problems retrieving past valuation and appraisal reports from firms due to the confidential nature of the reports.

2.      The number of responses to questionnaire addressed to estate surveyor and Valuers  about the operation of their firms and experience on matter such as how they incorporate risk and report it in their valuation and investment appraisal report has become difficult to determine as the number of firms who actually carryout these type of reports are limited in number.

3.      It was also observed that most firms don’t actually incorporate risk in their valuation and investment appraisal report. This posed a serious challenge because of the availability of very little evidence to prove the incorporation of risk in appraisal report and ascertaining the technique that has been used to incorporate these risks

4.       It was discovered that appraisal reports are not frequently prepared due to the present economy situation in the country. The number of reports carried out has also reduced seriously over the year. Thus the findings of this study has to be based on limited reports that were available